Euro on brink of dollar parity: what’s happened and what’s next?

While the euro has been weakening against the US dollar for some time, it is now on the verge of breaking through the psychologically-important parity level.

Why is the euro on cusp of parity?

Europe has been at the epicentre, both regionally and economically, of the Russian invasion of Ukraine. The region’s dependence on Russian gas, Germany in particular, is in stark contrast with the rest of the world. Higher energy prices have been a significant burden on households and industry, leading to a downbeat growth scenario. 

One example of how this is feeding into the macro data is the fact that Germany recently posted its first monthly trade deficit since 1991. This was due to high import costs as well as weaker demand for exports. Currency markets are one avenue for investors to position for a European recession.

However, there remain further downside risks to the current weak growth environment as gas rationing becomes a real possibility. Should this materialise we will be looking at an even more bleak growth scenario. 

Both German and French government officials have expressed concern about this risk, and are planning for how to cushion the blow to businesses and consumers alike.

Though policymakers have looked to offset the shock and shield consumer real incomes, measures announced so far are insufficient to fully absorb it. The prospect for structural stagflation is high if gas rationing becomes a reality. The fear of this scenario has intensified the weakness in the euro over recent weeks.

Why is dollar so strong?

On the flip-side, the US dollar has been strong across the board in 2022, with the broader US dollar trade weighted index up just shy of 10% year-to-date. The US economy is much more self sufficient when it comes to key commodity markets, in particular natural gas. 

Higher inflation in energy and food is having negative consequences globally for growth, which is leading to increasing evidence of demand destruction across many economies as central banks tighten policy. In this environment investors are seeking the safety of the US dollar and hoarding US dollar cash.

Most central banks are racing towards neutral rates to contain inflation. The Federal Reserve (Fed) is moving much faster than the European Central Bank, however, which has led to an interest rate differential of around 3% based on current market rates. 

This 3% yield advantage in favour of the US dollar is inducing investors to park money in US dollar cash, particularly in a world of so much economic and geopolitical uncertainty.

What is our outlook from here?

The currency market is already discounting a pessimistic growth scenario for Europe, but if gas rationing becomes a reality the trend for euro versus the US dollar will be lower still. 

The path for Europe weaning itself off Russian gas is not straightforward and there is no quick fix. The unfortunate reality is that President Putin holds many of the cards in terms of Europe’s ability to store enough gas ready for winter.

We are also watching how the Fed reacts to up-and-coming inflation and employment data. The Fed is effectively the central bank of the world, given so many assets are still priced in US dollars. 

Given the monetary policy tightening through both policy interest rates and quantitative tightening, the Fed is facing a narrow path in trying to engineer a soft landing. We believe it will struggle to achieve this.

As economic data weakens and inflation falls, any sign that the US central bank is close to peak tightening will relieve some of the upward pressure on the dollar. We are not there yet though.